Ch. 13: U. S. Inflation, Unemployment and Business Cycles Ø Demand-pull and cost-push inflation. Ø SR and LR tradeoff between inflation and unemployment (Phillips Curve) Ø Business cycle theories.
The Misery Index ØMI proposed by Arthur Okun in 1970 s ØMI = inflation rate plus the unemployment rate. ØMI peak: 21 in 1981 ØMI minimum: 6 in 1964 and 1999. ØMI in 2007: 4. 5% unempl + 4. 0% inflation = 8. 5% ØWe want both low inflation & low unemployment – are there trade-offs between the two?
Inflation and Unemployment in U. S. 1950 -2008
According to the U. S. experience, inflation tends to ___ during a recession and unemployment tends to ___ during a recession. 1. Rise; rise 2. Rise; fall 3. Fall; fall 4. Fall; rise 20
Real GDP and the Price Level: 1948 -2008
The Evolving U. S. Economy Inflation The upward movement of the dots shows inflation. Recession Leftward movement of dots shows declining real GDP Economic Growth The rightward movement of the dots shows the growth of real GDP.
Inflation Cycles ØIn the long run, according to equation of exchange: • inflation = %ch in M + % ch in V - %ch in y • inflation occurs if money grows faster than potential GDP. ØIn the short run, • Inflation can be initiated by –Increases in AD (demand pull inflation) –Decreases in SAS (cost push inflation)
Inflation Cycles ØDemand-Pull Inflation • starts because AD increases • can begin with any factor that increases AD. • Examples –Monetary policy & interest rates –Fiscal policy: government spending or taxes –Exports (value of $ or foreign income levels) –Investment (expected profits, technological advances) –Consumer expectations
Inflation Cycles: Demand Pull ØStarting from full employment, an increase in AD • Increases P (spell of inflation) • Increases RGDP • Creates inflationary gap
Inflation Cycles: Demand Pull Since unempl < natural rate • money wage rate rises • SAS shifts left • P rises (another spell of inflation) • RGDP falls until GDP=potential GDP • Inflation is finished unless AD increases again.
Inflation Cycles: Demand Pull Demand-Pull Inflation Process • AD must continually increase so that the process described above repeats itself • Although any of several factors can increase AD to start a demandpull inflation, only an ongoing increase in the quantity of money can sustain it.
If there is a decrease in AD, the short run effect is to _____ prices, ____ real wages, and cause unemployment to _____. 1. 2. 3. 4. Decrease; decrease; increase Decrease; increase Increase; decrease None of the above 20
Inflation Cycles: Cost Push ØCost-Push Inflation • starts with an increase in costs • Possible sources of increased costs: – An increase in the money wage rate –An increase in the money price of raw materials (e. g. oil) –Natural disasters –Regulation (e. g. carbon taxes) • Results in decrease in SAS
Inflation Cycles: Cost Push Initial Effect of a Decrease in AS ØA rise in the price of oil decreases SAS and shifts the curve leftward. ØReal GDP decreases and the price level rises. Ø“stagflation” (higher prices, less output)
Inflation Cycles: Cost Push Aggregate Demand Response ØThe initial increase in costs creates a one-time rise in the price level, not continued inflation. ØTo create inflation, AD must increase after AS decreases. ØAlthough any of several factors can increase AD to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.
Inflation Cycles & Inflation Expectations Expected Inflation ØIf inflation is expected, • AD increases • AS decreases as workers negotiate wage increases to offset expected inflation. ØMovement along LAS curve • No change in real GDP, real wages, or unemployment
If there is exceptionally good weather in the U. S. , this should cause SAS to _____. The short run effect of this is to _____ prices and _____ real GDP. 1. Decrease; increase 2. Increase; decrease; increase 3. Increase; increase 4. None of the above 20
Inflation Cycles & Inflation Expectations ØWhen the inflation forecast is correct, the economy operates at full employment. ØIf AD grows faster than expected, • Inflation > expected • Real wages decrease –Real GDP increases above potential –Unemployment rate falls below natural rate Ø If AD grows slower than expected • Inflation < expected –Real wages rise –Unemployment rate rises above natural rate
AD/AS representation of impact of inflation > expected inflation
AD/AS representation of impact of inflation < expected inflation
If the Federal Reserve creates more money than people expected, in the short run, this will cause real wages to ____ and unemployment to______. 1. Rise; rise 2. Rise; fall 3. Fall; fall 4. Fall; rise 20
The Phillips Curve ØPhillips curve • shows the relationship between the inflation rate and the unemployment rate. ØSR Phillips curve –Shows tradeoff between inflation and unemployment holding constant » The expected inflation rate » The natural unemployment rate ØLR Phillips curve • shows the relationship between inflation and unemployment when the actual inflation rate equals expected inflation • vertical at natural rate of unemployment
The Phillips Curve ØA short-run Phillips curve (SRPC) • As inflation increases, unemployment decreases • AD/AS explanation. ØIf inflation=expected, unempl= natural rate. Ø If inflation>expected, unempl<natural rate ØIf inflation < expected, unempl>natural rate
The Phillips Curve ØThe long-run Phillips curve (LRPC) • vertical at the natural unemployment rate. • intersects SRPC at expected inflation rate. • Shifts only if natural unemployment rates rises or falls –Unemployment insurance –Demographics of labor force
The Phillips Curve ØSRPC shifts up/down as inflation expectations rise/fall
If the Federal Reserve cuts interest rates unexpectedly, this should cause 1. A movement downward along the Phillips curve 2. A movement upward along the Phillips curve 3. An upward shift of the Phillips curve 4. A downward shift of the Phillips curve 20
If the general public begins to believe that the Federal Reserve stimulus is going to lead to higher inflation in the future, this should cause: 1. A movement downward along the Phillips curve 2. A movement upward along the Phillips curve 3. An upward shift of the Phillips curve 4. A downward shift of the Phillips curve 20
The Phillips Curve in U. S.
Business Cycles Two approaches to understanding business cycles are: § Mainstream business cycle theory § Real business cycle theory Mainstream (Demand Side) Business Cycle Theory Because potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP.
Business Cycles Real Business Cycle Theory ØArgues that random fluctuations in productivity are the main source of economic fluctuations. • fluctuations in the pace of technological change. • international disturbances, climate fluctuations, or natural disasters. • rapid productivity growth generates expansion; slow productivity growth (or decreases in productivity) cause contraction. • productivity growth affects » Investment and interest rates » Labor market and wages
Real Business Cycles: Investment Ønegative productivity shock: • investment demand loan demand falls • Interest rates fall Ø reverse happens for positive productivity shock
Real Business Cycles: Labor ØNegative productivity shock • Labor demand decreases • Labor supply decreases because of lower interest rates (above) and intertemporal subst • Employment and the real wage rate decrease (assuming LD shift larger than LS). • Reverse happens when there is an expansion caused by rapid productivity increase.